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As a small business owner, it is crucial to understand the different between the concepts of gross profit and net profit. These two metrics are both important in small business accounting and ultimately upholding your business's financial health. This is why we've compiled this short guide to gross profit vs net profit.
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Gross profit - explained
Gross profit describes a company's income after production cost or cost of goods sold (COGS). Your company's gross profit shows how well you are managing the cost of production. The gross profit helps inform improvements in production to make your company work more efficiently. The income, or revenue, is the total amount earned through sales over a specified period, while COGS describes a range of costs deriving from the production of goods. This can include costs for labor, material, supply, inventory, repairs, utilities, and shipment. However, this figure does not include fixed costs such as rent or staff salaries.
Calculating gross profit
The formula for gross profit is as follows: Gross Profit = Revenue minus Cost of Goods Sold. We recommend using net sales figures to take into account discounts, deductions, and refunds.
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Net profit - explained
When calculating your company's net profit, you subtract all the costs incurred by your business from the revenue. The net profit is also often described as the bottom line, as it is typically shown at the bottom of an income statement. Expenses and costs included in this calculation range from loan and debt interests, administration costs, tax payments, and depreciation to overheads and operating costs. The costs incurred, unlike the cost of goods sold, are recurring - you will still have to pay rent or pay your interest on a loan, regardless of how many goods you produce. The revenue part of the calculation includes short-term investments and any income made from the sale of assets. Net profit subtracts all costs and expenses and adds all income.
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Calculating net profit
The formula for gross profit is as follows: Net Profit = Total Revenue minus Expenses.
Which figure is more useful?
Gross profit represents an opportunity for your to understand how your company creates profit against direct costs/ production costs, net profit provides you with a good overview of your business's structure and operations. By taking into account recurring costs like operating expenses, income taxes, and costs incurred by fixed assets such as property rented, net profit gives you a more holistic picture of your business. However, when you calculate gross profit, you get an accurate picture of the operating profit and total sales revenue after producing products which can give you an idea of how efficient your production process is.
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